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Gulf producers navigate the recovery

Middle East oil producers have proved time and again they have the capital, know-how and political will to be leaders of the global industry, writes Bill Farren-Price

Opec's 50th birthday, in September, has given commentators the chance to measure the organisation's achievements in the historical context. Most agree that the early decades saw Opec feeling its way in nascent oil markets, while governments boosted sovereign control of their oil sectors. In more recent years, and following the destructive conflicts between member countries that blighted the 1980s and early 1990s, Opec producers have burnished their international credentials with solid international diplomacy and a renewed commitment to improving data quality, transparency and exchange with their international partners.

Rising to the challenge

While the early 1970s may be best remembered for the nationalisation of oil industries and the Arab oil embargo, Opec actions in the past couple of years have reinforced the organisation's reputation for moderation and responsibility. Since the 2008 global financial crisis broke, Opec's swift move to agree landmark oil-output cuts in response to collapsing global demand was sufficient to stabilise oil prices in a new range around $70-80 a barrel. Late 2008 was not the time for fine-tuning, but for a bold gesture and Opec rose to the challenge, delivering a clear statement of intent through its unprecedented production cuts of 4.2m barrels a day (b/d).

Moreover, as hopes for a broad economic recovery in 2010 have given way to a more complex and risk-laden outlook, that hard-won oil-price stability has become more important. With underlying oil fundamentals weakened by patchy demand recovery and rising stocks, stable prices represent no small victory for the group. Saudi Arabian King Abdullah bin Abdulaziz's readiness to be explicit about a price target of $75/b has helped establish the sweet spot that balances adequate returns to producers, incentivising new production both within Opec and outside, while avoiding headwinds to the global economic recovery.

Critics may point to weak compliance within the group. Certainly, output discipline has always been a challenge over the years and now is no different, with compliance from Opec's 11 members bound by the agreement down to around 55%. Senior Opec officials regularly call on member countries to show restraint. But this perennial Opec problem has always presented a challenge and historical evidence demonstrates that when prices suffer, compliance improves.

Paradoxically, present weak compliance with output targets will make it easier for the organisation to respond to any price weakness further down the line, since a renewed commitment to improved compliance and the removal of surplus barrels will not need a new formal agreement, which would require consensus on individual production levels.

But the stability of oil prices around the $70-80/b zone (see Figure 1), defying record US oil inventories and inconsistent demand recovery in some OECD countries, raises some serious questions about the near- to medium-term risks to oil prices – many of which are not oil related.

Early in 2010, producers expressed reasonable expectations that GDP growth would accelerate in the key OECD economies towards the end of 2010, supporting the swifter recoveries seen in developing Asia and Latin America. The expectation of 2010 as the turnaround year and talk of a "recovery summer" only a few months ago now seems to have been too optimistic.

Much has been written about the dangers of a double-dip recession and with oil demand inextricably linked to economic growth, this is a significant concern for oil producers in the short to medium term. With few relevant economic precedents, the 2008 crisis has raised thorny questions about the limits of monetary stimulus and whether government banking-sector bailouts and debt purchases by central banks have simply deferred, rather than eliminated, what is in essence a multi-year, painful structural adjustment away from cheap and excessive government and personal credit. If the economic problem is more than cyclical, then it seems inevitable that monetary easing alone will not be enough to return the global economy to sustainable trend growth.

More likely than a genuine double-dip, which would require two consecutive quarters of contraction and seems unlikely, would be a protracted period of bumping along the bottom, as debt is paid down, asset bubbles are allowed to deflate and labour markets recover. Under that outcome, global oil demand will probably hold below trend-growth levels, extending the period of time that Opec will have to maintain output constraints.

While few expect oil's long-term share of the energy mix to diminish, the lesson must be that patterns of oil consumption are changing in developed countries. The climate-change debate can only enhance that shift in behaviour. To date, oil prices have been resilient in the face of these downside risks. So what are the factors that could trigger fresh traction for weak oil fundamentals?

First, any sign of weakness in Chinese, Indian and Middle East oil demand would shake confidence in oil demand forecasting. These consumers' resilience in the face of the global downturn has helped limit the effect of declining European oil consumption and patchy recovery in the US.

Second, a weaker US dollar has helped underpin commodity prices over the past year. But any new bout of economic contagion or credit concern could prompt a new flight to safety, which has tended to strengthen the dollar, pressuring commodity prices.

Third, while most serious commentators believe the recent hump in inflation will be temporary and see little risk of sustained rising inflation for the foreseeable future, any signs that structural (non-imported) inflation is becoming embedded will cause a headache in central banks that operate inflation-target policies. Even the slightest uptick in interest rates could prompt a reassessment of commodities and oil as an asset class.

These risks to oil prices come as global economic co-ordination has faltered. While the G20 and central banks were commendably united in their responses to the crisis in the early months, a failure to continue that co-ordination has produced independent policy interventions across the globe in recent months. Whether in currency (Japan), trade (the US) or fiscal measures (the EU), a lack of co-ordination risks derailing the recovery. Added headwinds will come from the jobless recovery – a failure of policy makers to create the conditions for an improvement in industrialised labour markets. Failure to get to grips with unemployment means social pressures will bubble up over the next year, making international co-ordination even harder for governments.

These are not just problems for the developed countries. While China has to date avoided a hard landing, the Beijing government's efforts to refocus economic activity on domestic demand bring a whole set of risks to the table.

Mideast producer challenges

In the Middle East, oil producers face many of the social and economic challenges encountered by economies in transition elsewhere. While these countries continue to derive the bulk of state revenue from oil and gas, and strategies to capture value further down the hydrocarbon chain are now firmly entrenched, the growth of non-oil private-sector activity has continued to struggle, particularly with credit availability limited in the aftermath of the financial crisis.

For the oil industry itself, development and operational costs have remained sticky for some time – and with untapped oil reserves requiring the application of advanced technologies for recovery, the expectation must be that drilling and recovery costs will increase over time, requiring a higher marginal oil price. While $70/b is sufficient to cover most conventional and unconventional oil development projects for now, the constant drive outside Opec towards developing oil in deeper water and in frontier provinces far from infrastructure will lift costs over time, exacerbating the effect of rising raw material, labour and technology costs.

In this context, Middle East oil will move back to centre stage over time, as the global industry turns towards the world's main reserves holders. At end-2009, Saudi Arabia, Iran, Iraq, Kuwait and the UAE accounted for 0.716 trillion barrels, or some 54%, of global proved oil reserves (see Figure 2).

In the medium term, ample spare capacity concentrated in the Gulf states will enable Opec to soak up a rise in the call on its crude when it comes. For 2011, the strong growth in Opec natural gas liquids, non-Opec crude and non-conventional oils means that the call on- Opec crude will be little changed.

But just like towing a broken-down car, when the slack has been taken up in the tow rope, there is usually a sharp jolt. Opec will need to ensure it is ready for the moment that alternatives fade and the focus returns to Opec oil reserves. With 5m-6m b/d of capacity mothballed, this may take a few years, but is inevitable as long as oil holds its own in the overall energy mix, which all serious commentators believe it will.

Beyond existing production capacity, Iraq's first steps towards a capacity expansion that it hopes will lift the country's output to over 10m b/d are under way. Few would question the size of the challenge in Iraq, where dysfunctional politics has left the country without a full-time government six months after elections. Iraq's political miasma will inevitably overshadow the oil sector in the years ahead, but support for oil sector development is a common thread in an otherwise difficult outlook.

With work on the country's four largest southern ventures under way, expectations for an additional 400,000 b/d of Iraqi production by the end of 2011 – taking total output capacity close to 3m b/d – are reasonable. All other things being equal, the momentum should build steadily through 2012 and 2013 as international oil companies and their Iraqi partners bring large new increments on stream. How Opec and Iraq will choose to integrate that supply is another question, but few query Iraq's right to rebuild its infrastructure and institutional capacity after years of war, sanctions and foreign occupation.

If the supply side looks healthy for Middle East oil producers, rising domestic oil demand will be a growing concern, if not tackled. At present, oil demand in Gulf states is rising at an average 7-8% a year, buoyed by a combination of low pricing for refined products (both transportation, industrial fuels and LPGs) and a trend towards the use of liquids (crude and fuel oil) in power generation and water desalination. With natural gas availabilities constrained across the region and demand for electricity also rising fast, the need for a strategic shift in domestic energy policy is urgent and failure to act will, over time, see oil available for export squeezed.

Part of that picture is an increased seasonality for domestic demand, where requirements for crude burn is driven much higher during the hot summer months. For now, spare production capacity means this pattern is not so visible, but a tighter supply picture over time will make domestic demand growth and greater seasonality more prominent.

The way forward

So what policies should Opec's Middle East producers prioritise in the wake of the financial crisis to drive economic and social development at home?

First, producer governments must build on their successes of the past 15 years in capturing value down the hydrocarbon chain beyond the drill bit, investing in downstream industries that will compete globally, meeting both regional and international demand. The development of Gulf fertiliser, steel, aluminium and phosphates industries are huge regional success stories and the next phase of that process should encompass the development of technologies and manufacturing bases for finished products that will also address the region's need to create employment opportunities.

Second, the development of natural gas and a greater emphasis on cross-border gas trading would reinforce regional commercial ties and free up liquids for export. With prospects for international gas markets so uncertain amid the development of shale gas, regional gas producers should look closer to home for new markets. Coupled with more realistic pricing, Middle East gas reserves should directly leverage the development of non-oil private-sector expansion, while safeguarding liquids production for export.

Third, the drive towards better quality data, transparency and international dialogue that has characterised Opec's fifth decade, should be adopted more broadly by Gulf producers. As the region's economic power increases, Gulf oil producers should step up and engage more vocally in international economic and political fora, making their voices heard and punching their weight on the international stage. Constructive international engagement will drive foreign direct investment, while increasing regional co-ordination and trade.

Middle East oil-producing countries and their national oil companies have proved time and again they have the capital, know-how and political will to be leaders of the global industry. While the macro-economic context presents greater challenges than 10 years ago, the Gulf's oil decision-makers will succeed best when they play to their strengths: a phenomenal natural resource endowment complemented by a sophisticated and experienced policy-making cadre.

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